New Year…New Play Book

Most of the farewells for 2021 were more a good riddance to an annus horribilus! Everyone seems to want to put the COVID impaired year, along with the social and economic disruptions it caused, behind us. Unfortunately, the major factors impairing the economy, namely COVID, inflation and the Fed are likely to persist into 2022 and will make the first half of 2022 very challenging and probably more volatile than our recent experiences. Ironically, despite these worrisome and persistent factors, 2021 was a great year for investors! The major equity indices posted 20%+ returns, highlighted by the S&P 500 index which returned over 27.5%! Can investors expect further high returns in 2022 while these factors remain? Possibly. But the path is likely to be more challenging and volatile.

The COVID epidemic has defied the experts and policy makers from the start. From the original two-week “flatten the curve” economic shutdown, to competing mask and vaccine policies, to school closings, return to work delays and travel restrictions, the end of the pandemic has proven elusive. Today, the Omicron variant is ravaging the globe with new cases exceeding over 1 million! The good news is that while case numbers are skyrocketing, hospitalization and death remains relatively low. Based on early studies, it appears Omicron is highly transmissible but causes relatively mild symptoms. While it is expected that Omicron will continue to infect a large part of the global population, it is hoped that it is running its course and soon will peak. Based on history, it is possible that this is COVID’s last stand. Let’s hope! What is clear, however, is that Omicron has had an impact on economic activity and estimates for 4th Quarter 2021 GDP and 1st Quarter 2022 GDP growth have been reduced significantly. The markets are forecasting a quick recovery in the 2nd quarter of this year, but that is based on the cooperation of Omicron. Been there, done that. Hope springs eternal!

Inflation ended 2021 at the highest levels in at least 20 years. The three factors driving inflation have been and continue to be supply chain issues, labor shortages and high energy prices. While inflation is likely to come down from its lofty levels, it will remain elevated in 2022. This blog has discussed all these factors, and I remain concerned that the markets and the Fed may be too optimistic on inflation. The hope that supply chain issues would dissipate as the seasonal demand ended simply has not happened, at least not yet. There is evidence that increased capacity is on its way in several key categories like semiconductors and basic commodities. However, the supply chain backlogs continue as demand for goods remains robust and the supply chain system simply can’t adjust. The recent Omicron spike is not helping on this front! Our port system is hampered by poor efficiency; the LA and Long Beach ports rank 325 and 333 globally. Government, labor, and environmental policies (local, state, and federal) prohibit quick fixes. The supply chain disruption will get better, but I fear it will persist far longer than many expect. Its impact on inflation may diminish as capacity increases, but it will remain a problematic contributor to inflation.

The labor market is the tightest it has been in 30-40 years. Hourly earnings and employment costs are rising 4-5%, roughly a 30-year high. This blog has discussed the impact of unemployment benefits, early retirement, immigration, increased self-employment, and child-care issues as major factors impacting labor inflation. It remains to be seen how 11+ million job openings are going to be filled. Labor will continue to be a major source of inflation for the foreseeable future.

Energy prices will continue to fuel (pun intended!) inflation. Governments around the world have created environmentally friendly, renewable energy policy that has significantly reduced capital investment in traditional oil and gas energy sources. It is estimated that CapEx. in oil and gas is down 75% from peak levels and it is not recovering despite increased prices! It is estimated that global oil demand will increase by 3.5 million barrels per day to 99.8mbd in 2022 At the same time, production has declined. Everyone wants to save the climate, but in the meantime, they still need to heat the house and drive to work! Michael Cemblast of JP Morgan put it this way; “if they (policy makers) reduce supply of fossil fuels faster than they reduce demand for them, they run the risk of higher energy prices, energy dependence that can border on servitude and inadequate energy supplies that can lead to power rationing on homes and businesses.” In many respects, we are already there. Prices are high. Europe is in jeopardy of dependence on Russian energy supplies and California has already experienced rolling black outs. My point is not a political one. That said, I find it nearly impossible given the current political environment that any of these renewable energy policies will be reversed any time soon. Therefore, there will be a prolonged, global supply/demand energy imbalance. Energy will be a source of inflation for quite some time.

The real question to be asked is how the Federal Reserve Bank will react to this current economic environment. This environment is unique due to COVID. Strong demand that cannot be adequately supplied. Low interest rates can’t fix this mismatch. The historic Fed playbook simply doesn’t apply. Historically, economic cycles ran this way. The economy would heat up; the Fed would tighten monetary policy (usually too far), the economy would slow and enter recession, unemployment would jump; demand would fall, and prices would contract; the Fed would then cut interest rates to restore demand and the cycle would begin renewed.

In today’s environment, the Fed’s playbook is broken! Low demand and high unemployment are not the problem. Demand is robust; so robust it is causing the supply chain disruptions! Unemployment is 4% and labor markets are tight, yet 8 million people remain out of the workforce! Consumer and corporate balance sheets are strong. Monetary and fiscal policy is already highly accommodative even as inflation is near its recent high levels. COVID makes today’s environment unique, and the old playbook of accommodative monetary policy is unlikely to work. The Fed has more or less conceded this thought, has a renewed focus on inflation and has set a course to reduce monetary accommodation and perhaps start tightening policy soon in the Spring.

Will the Fed go too far? The markets don’t think so. The equity markets trade at record high levels and valuations remain historically high. The 10-year Treasury note yield still hovers at a benign 1.65%. After all, real interest rates are still negative, and it is unlikely the Fed would move so dramatically to force real rates into positive territory. High federal debt levels provide another incentive for the supposedly independent Fed to keep rates negative! This suggests the market is anticipating that any increases in interest rates will be modest. The impact of a robust demand, improving supply chain conditions, low inventories, strong earnings growth, and healthy consumer and corporate balance sheets should more than compensate for modestly higher interest rates. If COVID does, in fact, begin to recede (hopefully!) as an economic worry, economic growth could be significant.

Unless persistent and pervasive inflation forces the Fed to use a more aggressive playbook than the market’s modest interest forecasts project. I continue to worry that the factors driving the inflationary environment are more structural than transitory and are a result of policies that will be difficult to reverse. I don’t see a quick solution to the labor and energy issues pestering the economy; therefore, inflation may be persistent.

This doesn’t mean an end to our 7 straight quarter bull market. However, it does mean the equity markets are subject to sudden and intermittent corrections. Equity valuations remain high, even after considering low interest rates. The market is highly concentrated. If you exclude the top 5 stocks, the NASDAQ index was down nearly 20% in 2021! The markets have already seen an increasing reluctance to stay in the speculative areas (SPACs, IPOs, Fintech, COVID “winners”, renewable energy) of the markets.

I don’t envy the Fed. They are in a tough spot. COVID is still impacting economic growth while inflation is elevated. The old playbook doesn’t work. What will the new playbook look like and will it work? With so much uncertainty entering 2022, volatility must be expected. Patience will be required.

Happy New Year!